By SJS Investment Services Intern Jake Matthews.
You probably remember working your first job. The feeling after receiving your first paycheck is both rewarding and refreshing. But now, how do you store your hard-earned money? How do you protect your money from inflation? What steps should you take now to save for retirement?
Knowing which investment accounts to store your money can be challenging. Yet, the rewards to investing can be tremendous over your lifetime. Choosing the right investment accounts to use at a young age can be the first step in building generational wealth. Below, we detail four investment accounts that can aid you in growing your wealth over time.
IRA: Roth & Traditional
One of the most popular investment accounts is the Individual Retirement Account (IRA), which offers tax advantages to encourage U.S. workers to save and invest for retirement. There are two types of IRAs available to most income-earning U.S. workers: Roth IRA and Traditional IRA.
Roth IRAs and Traditional IRAs are subject to many of the same rules. In any given year, as long as you have enough taxable income, you can contribute up to $6,000 ($7,000 if age 50 or older) to a Roth IRA and / or a Traditional IRA. You can open a Roth IRA or Traditional IRA at many large brokerage firms in the U.S. (such as Schwab, Vanguard, and Fidelity), and can invest in a very broad range of investments including mutual funds, ETFs, stocks, and bonds. While the money is held in your Roth IRA or Traditional IRA, you do not pay taxes on any dividends or realized gains on your investments. Any money you withdraw before age 59 1/2 may be subject to income taxes and a 10% penalty.[1]
There are important differences between a Roth IRA and Traditional IRA. For a Roth IRA, you contribute after-income tax money, and any investment gains that you withdraw after age 59 1/2 are not taxed. If you are a single tax filer, your contribution limit starts declining once you earn $125,000 in a year, and you cannot contribute if you earn more than $140,000.[2]
For a Traditional IRA, you contribute pre-income tax money, and money (both what you contributed and any gains) that you withdraw after age 59 1/2 are subject to income taxes. If you are a single tax filer and have an employer-sponsored retirement plan, you gradually lose the tax advantages of a Traditional IRA once you earn over $66,000 in a year, and lose nearly all of the tax advantages after you earn more than $76,000.[3]
Particularly for young investors, we believe that a Roth IRA is generally more beneficial over the long-term than a Traditional IRA.
401(k): Traditional And Roth
Another popular investment account for young investors is the 401(k), a retirement account sponsored by your employer. While all employers with a 401(k) offer the Traditional option, only some offer the Roth option. 401(k)s are subject to many of the same rules as IRAs.
Unlike IRAs, no matter how much you earn, you can contribute up to $19,500 ($26,000 if age 50 or older) of your income per year to a 401(k). Because 401(k)s are employer-sponsored accounts, many employers will match their employees contributions up to a specified amount. 401(k)s usually have limited investment options (typically a lineup of mutual funds), and are often subject to higher annual expenses than IRAs. Instead of a 401(k), certain employers may offer a 403(b), which has similar rules.[4]
Many investors retire with their 401(k) as their single largest investment account.
Health Savings Account (HSA)
Some employer-sponsored health insurance plans offer for employees to contribute to a Health Savings Accounts (HSA), which allows you to save pre-tax dollars to pay for future medical expenses. Some employers also contribute to the HSA. For an individual, the total employee and employer contributions cannot exceed $3,600 ($7,200 for a family) per year. Some HSA plans allow you to invest in a limited lineup of mutual funds, and any dividends and gains are not taxed as long as they are used for future medical expenses.[5]
Because of the tax advantages, many young investors use their HSA as an investment account for the long-term.
529 Plan
If you plan to go back to school one day or have other qualified education expenses, you can consider contributing to a 529 Plan. You contribute after-income tax money to a 529 account, which can be invested in a limited number of investments. Any money you withdraw from the 529 account is tax-free as long as the money is used for qualified education expenses.[6]
Each state offers a different 529 plan, and you are able to participate in whichever state’s plan is most beneficial to you. Each state offers a different investment lineup, contribution limit, state income tax benefits for residents, and expenses. If you do not use all of the money in your 529 account, you can change the beneficiary to a qualifying family member with no penalty, subject to gift tax rules.[7]
Overall, a 529 account can be a great way to start saving for future education expenses for you or your family.
Benefits Of Compounding Returns
Albert Einstein reportedly said, “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”[8] By using these four investment accounts, you can invest to potentially allow your wealth to compound for the long-term while paying less in taxes.
To demonstrate this, the below graph shows what would happen if you contribute the maximum to your Roth IRA ($6,000 in 2021, expected to grow 2.00% annually due to inflation) at the beginning of each year, and invest the Roth IRA in a portfolio that earns a 5.00% annual expected return.
Graph created by Jake Matthews, and reflects hypothetical information based on the assumptions above. Actual investment results may be materially different than hypothetical returns. See Important Disclosure Information.
After 50 years, the above Roth IRA grows to over $1,842,920.47. That’s the power of compounding.
Conclusion
As a young investor, knowing which investment accounts are available to you as well as the associated benefits & tradeoffs can dramatically help you grow your net worth over your lifetime. We believe these four accounts provide a very strong foundation for any investor to begin the journey of saving for their future.
About The Author:
Jake Matthews is a rising fourth-year undergraduate student at Miami University, majoring in Economics & Finance. Jake is a member of Miami University’s Track Team, running the 200-meter and 400-meter. Jake enjoys learning about a wide variety of industries, particularly about alternative investments including real estate, collectibles, and cryptocurrencies.
Jake spent the last ten weeks interning at SJS, helping with client portfolio analyses, investment recommendations, and improving financial planning processes. We are very grateful to have gotten to know and work with Jake this summer, and we wish him all the best as he heads back to college!
Important Disclosure Information & Sources:
[1] “Individual Retirement Arrangements (IRAs)“. IRS, irs.gov.
[2] “Amount of Roth IRA Contributions That You Can Make For 2021“. IRS, irs.gov.
[3] “IRA Deduction Limits“. IRS, irs.gov.
[4] “401(k) Plans“. IRS, irs.gov.
[5] “Health Savings Account (HSA)“. Julia Kagan, 01-Mar-2021, investopedia.com.
[6] “An Introduction to 529 Plans“. U.S. Securities and Exchange Commission, 29-May-2018, sec.gov.
[7] “Complete Guide to 529 Plans“. Julia Kagan, 07-Jul-2021, investopedia.com.
[8] “Why Einstein Considered Compound Interest the Most Powerful Force in the Universe“. Jim Schleckser, 21-Jan-2020, inc.com.
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